PERSPECTIVES

OUR CENTRAL SCENARIO

ÉRIC BERTRAND
Deputy Chief Executive Officer,
Chief Investment Officer
OFI INVEST

Central banks continued to live up to expectations. The US Federal Reserve stuck with the status quo, and the European Central Bank (ECB) raised its key rates by 0.25%. The economy continues to hold up well, in particular in the United States, and this is making a slowdown in its jobs component and, hence, in inflation, even less likely. Against this backdrop, both central banks are likely to remain focused on combating core inflation, which has stabilised but is taking time to actually recede. We forecast an additional 0.25% rate hike by both the Fed and the ECB this summer, probably followed by a second one this autumn in Europe. The plateau of stable short-term rates is likely to last rather long in Europe and then in the US.

We are sticking to our yield curve buying targets on 10-year maturities at, respectively, 2.50% and 3.00%, for Germany and France and at 3.75% for the US. There is still a risk of a delayed slowdown in growth and inflation, which could push the central banks into further monetary tightening. But if that happens, we believe the long section of yield curves would anticipate a stronger-than-expected economic slowdown with only a moderate impact on long bond yields (barring an upturn in inflation).

As they have been over the past few months, investment grade and high yield corporate bonds, in our view, are the sweet spot, with interest rates and credit spreads still offsetting one another. We believe that expected returns from the carry trade properly remunerates credit risk.

While European equity markets are headed back towards their highs, US markets are already above them, driven by strong economic growth. The recession expected in the US and the slowdown in Europe would tend to argue against adding to this asset class at this point. Indeed, the central bank tightrope walk already looks priced in, and risky assets would probably be punished in the event of further monetary tightening, if inflation stays high, or, on the contrary, if the economy landed hard due to all the tightening over the past year. We are therefore sticking to our conservative bias on the equity markets.

OUR VIEWS AS OF 06/07/23

Central banks continue to raise their key rates, and yield curves keep inverting further. The ECB is expected to reach its terminal rate soon, followed by a long plateau. Against this backdrop, long bond yields should remain in a trading range. Uncertainties over growth in the second half of the year call for some caution in rate directional strategies but do create some carry opportunities in bonds. We are therefore sticking to our buying targets of 2.50% and 3.00%, respectively, on 10-year German and French bonds and 3.75 on US T-notes. We are raising our money-market weighting, as the risk/reward there is especially attractive. There is also a risk that existing spreads will widen in corporate bonds but they are likely to be contained and offset by carry opportunities. While we have a slight preference for high yield, investment grade – with its longer maturities – could benefit from as interest rates and credit spreads offset one another.

Equity markets were on a remarkable ride in the first half. The most impressive performance was by the Nasdaq, but European indices were not far behind, albeit with less spectacular gains. The asset class was driven by two factors: 1/ the fact that long bond yields, which are a benchmark in valuing companies, have been deemed acceptable despite upward pressure on short-term rates; and 2/the fact that earnings forecasts have held steady for both this year and next year, even though downgrades had certainly been possible. Barring a change in these two fundamental parameters, the markets could have slightly more upside potential. However, any bad news on interest rates or earnings growth could drag down equity prices. Geographically, the United States still looks overpriced, while China, is unlikely to outperform due to its disappointing growth.

After a solid month of May, the dollar pulled back in June. Having traded mostly directionless since the start of the year, the dollar could have a role to play in an alternative scenario of a revival in inflation or a scenario of a rough economic slowdown. For the moment, the monetary policy gap between the US and the euro zone is unlikely to play a predominant role in the cross strategy, and we remain neutral. The yen later lost ground in June against all currencies and hit new historic lows against the EUR and CHF. The Japanese currency is being driven down by Western central banks’ hawkish anti-inflation policies and by the fact that monetary policy in Japan will be adjusted only very gradually. We are holding onto some exposure to the yen due to the gap with its fundamental value and because the Japanese yield-curve-control policy is due for an adjustment this year. Some experts suggest this could even happen at the July meeting.

MACROECONOMIC VIEW

NO SUMMER PAUSE BY CENTRAL BANKS

OMBRETTA SIGNORI
Head of Macroeconomic Research
and Strategy
OFI INVEST ASSET MANAGEMENT

Global growth held up better than expected in this first half of the year, thanks to the surprising resilience of the US economy and despite the weaker-than-expected Chinese reopening.

Chinese consumers remain tentative, while Americans have been true to their propensity to spend, particularly in services. At first, robust consumption was driven by excess savings accumulated during Covid, but we now believe the main factors in support are solid wage gains, the various measures rolled out to index US household income to the cost of living, and a still-tight job market. According to the latest estimate, first-quarter US economic growth was even stronger (2.0% on an annualised basis) than in the previous estimate), reflecting stronger consumption of services and a greater contribution of foreign trade.
All available data show that the economy should continue to growth by about 2% in the second half of the year, thus lessening fears of a recession in the short term. These data suggest that full-year US economic growth in 2023 will be between 1.5% to 2.0%!

MONETARY TIGHTENING HAS NOT YET PRODUCED ALL ITS EFFECTS

Clearly, the effects of past monetary tightening are still modest. That said, don’t forget that the Fed Funds rate was 1.0% in late May 2022. So, given that transmission of monetary policy historically takes about 18 months, probably not till early next year will the impact of the 425 basis points (bps) of key rate hikes show up fully in the economy, in particular via the channels of credit and business investment.
Total inflation has become gradually more moderate, thanks to the negative contribution of energy prices and the moderation of goods inflation. The process of disinflation is likely to continue, thanks to energy, as well as more moderate food prices and rents (the latter account for about one third of the basket of US consumer items). Inflation could soon slip below 4% in the US, but core inflation will remain higher. Inflation in services will probably be the last component to moderate, as that is where labour costs are the biggestticket item and are closely linked to wage momentum and, hence, tightness on the job market.
As demand is still solid, the muchawaited pause in the Fed’s monetary tightening will very likely be pushed back to this autumn. We expect at least one more (25 bps) hike in July, but, most of all, we don’t expect conditions to be right for an initial rate cut for a long time to come (barring the emergence of a systemic risk).

GROWTH HAS BEEN WEAKER IN THE EURO ZONE THAN IN THE US

The economy has been weaker in the euro zone than in the US. It has stagnated in recent months due to weaker private and public consumption, and our in-house models suggest, at best, stable economic activity in the second quarter. We expect economic growth to remain shaky in the euro zone, while being pulled in opposite directions – in one direction by the normalisation of energy prices, a further recovery from supply-side disruptions, the ongoing catching up in wages combined with lower inflation; and in the other direction by the effects of past rate hikes and the end of energy price caps. Inflation is receding in the euro zone for the same reasons it is in the US - total inflation is expected to slip below 4% in the coming months, driven first by its energy component and then by more moderate prices of manufactured goods and food. Like the Fed, the European Central Bank has turned its gaze towards core inflation, particularly inflation in services, owing to rising wages and the strength of the job market. The ECB has already flagged to markets its intention to raise its rates to 3.75% in July, while leaving the door open to one last hike, to 4% in September, as inflation in the euro zone is lagging inflation in the US and as there is not yet any proof of a true downturn in core inflation.

INTEREST RATES

SHORT-TERM RATES ARE APPROACHING THEIR EQUILIBRIUM PLATEAU

GEOFFROY LENOIR
Co-CIO, Mutual Funds
OFI INVEST ASSET MANAGEMENT

In June, the European Central Bank, the Bank of England and several other central banks (Switzerland, Canada, etc.) raised their rates further, in contrast to the US Federal Reserve, which opted for the status quo. Central banks are likely to reach their terminal rates soon, although projections of those terminal rates were raised a little this month. Despite these additional rate hikes and weaker growth indicators, such as PMIs, investors are not too concerned about GDP figures. Inflation is likely to remain above 2% until 2025, but the trend is downward. Unemployment figures remain low, companies are reporting satisfactory results, and wages are rising, which is supporting consumption.

HIGHER SHORT-TERM RATES AND AN INVERTED YIELD CURVE

As in the two previous months, the 10-year German yield remained in its equilibrium range around 2.5%, and credit spreads showed no signs of worsening.

Once again, it was short-term rates, i.e., less than two years, that rose. This has caused record inversions in the yield curve. The section between the German 2-year and 10-year yields has not been this inverted since 1992. The highest point in the curve is the 1-year rate, which favours money-market funds.
Now that rates have been raised, the question is when they will have to be lowered again. The market’s baseline scenario, which we share, is a soft landing in the economy. With this in mind, we expect rates to plateau for a relatively long period, all other things being equal. A longer plateau than in other past tightening phases, in our view, is justified for two reasons: 1/ because it generally takes 12 to 18 months to be able to judge the effects of monetary tightening; and 2/ the long period of 0% rates allowed issuers to refinance on advantages terms for a long period of time. There could be some nervousness in the US and Europe when the average financing rates of banks and businesses turns back up, but this is likely to be of greater concern to the markets in 2024.

A PRO-CARRY ENVIRONMENT

If central banks opt for a long plateau, as we expect them to do, it should be possible to avoid a hard landing, and there will be little upside potential on long-term rates.

We are therefore sticking to our neutral to positive stance on sovereign bonds, for their carry opportunities. Only a pro-growth Goldilocks scenario could push rates significantly higher, but this would be of short duration and would offer additional rate buying opportunities. In “peripheral” countries, Italian spreads are faring very well, at 155 bps above the Bund, a level hit in mid-month. Italian bonds are being supported not just by low political risks, but also technical factors. Italy’s issuance programme is lighter than Germany’s, and it already accomplished a large portion of it in the first half of the year. The second half of the year will be more favourable for European sovereign debt, as net issuance will amount to about half the amount of the first half. We remain particularly bullish on the entire euro bond asset class, money-market investments and investment grade corporate bonds, but also high yield bonds, which we feel are especially attractive and are worth overweighting in an allocation. A close eye will nonetheless have to be kept on idiosyncratic risks, as well as the real-estate sector, which generally feels the first effects of higher interest rates.

EQUITIES

ECONOMIC GROWTH AND EQUITY MARKETS ARE HOLDING UP WELL TO MONETARY TIGHTENING

ÉRIC TURJEMAN
Co-CIO, Mutual Funds
OFI INVEST ASSET MANAGEMENT

Equity markets posted further solid gains in June, putting the lie to the old adage “Sell in May and go away”! This didn’t seem to make sense, given that several central banks continued to tighten their monetary policy in an attempt to slow down inflation, at the risk of exacerbating the slowdown in the economy. For example, while a rate hike by the European Central Bank had already been priced in, those by the central banks of Canada and Australia were a surprise. And while the Fed opted for the status quo this time, keep in mind that 12 of its 18 members expect it to be necessary soon to raise rates again.

A BULL MARKET IN THE US

The S&P 500 gained more than 5% in June, bringing its gains to more than 25% since October 2022. This brought the US market officially into bull market territory. And the gains were broader-based this month than in previous months, as they were less focused on tech sectors. Moreover, the latest indicators could bear out that the Fed is managing its tightrope walk to perfection.

On the one hand, we are seeing a gradual receding in inflation indicators, proving that the Fed’s policy is paying off. And, on the other hand, growth in the economy has still not slipped below its potential. Higher wages, combined with greater wealth effects have allowed US household consumption (two thirds of US GDP) to increase by more than 3%. More surprisingly, residential construction seems to be recovering tentatively, with housing prices beginning to rebound and with an upward acceleration in building permits applications. All this despite the fact that mortgage rates have doubled in one year to more than 7% currently.

But the surge in industrial investment, especially in the tech sector, is due mainly to the acceleration of public spending under the Chips and Science Act and the Inflation Reduction Act, which were passed last year. However, questions remain on the capacity of other businesses to invest in the midst of so much uncertainty. The cautious message from Accenture* in June tends to raise doubts on this matter, as it lowered its forecasts for economic activity for 2023, based on clients’ lower appetite to launch new projects. However, the month’s performance shows that the market wants to continue seeing the glass half-full. At almost 20x earnings for the current year, there is still rather little room for disappointment.

SERVICES ARE DRIVING GROWTH IN EUROPE

The situation in Europe is still uneven, although the equity markets performed more than honourably in June. On the one hand, services still appear to be in a catching-up phase and continue to surf on consumers’ appetite for leisure, financed by surplus savings that remain substantial. And wage hikes planned for 2023 and 2024 should allow European household purchasing power to hold up to inflation that, in any case, will be trending downward. But on the other hand, manufacturing is in the doldrums, as seen in the long series of PMI figures that remain stuck below the 50 threshold between expansion and contraction in economic activity. This is a rude awakening after the surge in demand for goods in 2021, especially as China, European manufacturing’s top buyer, is having a hard time accelerating. Recent profit warnings, concentrated in the European chemicals sector, show how hard it is to sell off inventories built up when demand was robust. But, unlike the US market, the scenario of a slowdown is already well priced into European shares.
Japan ended June out front, with a gain of more than 6% in local currency. The Japanese market continues to be driven by an ultra-accommodative monetary policy and by its very strong tech sector. And yet, hopes arising from the Chinese reopening are taking time to materialise. The number of Chinese tourists is below expectations and is dragging down consumption. This summer will tell us more whether we are seeing an acceleration in the trend.

EMERGING MARKETS

MID-YEAR ASSESSMENT: DISAPPOINTMENT IN CHINESE EQUITIES, GOOD SHOWING BY EMERGING DEBT

JEAN-MARIE MERCADAL
Chief Executive Officer
SYNCICAP ASSET MANAGEMENT

Chinese equities have flatlined since the start of the year, which is a disappointment amidst a post-Covid phase of economic acceleration and after a promising initial rally. Emerging debt in local currencies, however, fulfilled the positive hopes that we had early in the year. What is the most likely scenario for the second half of the year?

A soft economic recovery and a very tense geopolitical context - that sums up the first half of the year in China. The government, which expected greater momentum in confidence, will have to take action to meet its 5% growth target, a target confirmed this week by Prime Minister Li Qiang.

Due to excessive debt, this time, the government had counted on monetary measures to support economic activity, rather than on a fiscal stimulus plan. But the reduction in banks’ required reserve ratio (from 11.5% in 2019 to 7.6% today) and interest-rate cuts have not been enough to restore the confidence of consumers, who have been hit by the real-estate crisis and a stubbornly very high unemployment rate of young graduates of more than 20%.

An illustration of low morale is the number of marriages in China, which is at a 40-year low, as is the birth rate. China is thus threatened by a sort of liquidity trap: financing conditions are easing, but households don’t want to invest or consume. They are paying off their debt and their savings rate is holding at a high level. More forthright stimulus measures will now be necessary. Several avenues are being considered, including a plan to issue “consumption coupons” in the amount of RMB 1,500bn, financed by an exceptional bond issue. This would give about 1000 yuan to each person in China.

On the geopolitical front, relations between China and the US remain very tense, and Antony Blinken’s visit to Beijing in June did not provide any significant relief. This climate has steered foreign investors towards the exits, with investments down by 5.6% in the first five months of the year. Workarounds are now being developed in production chains to deal with the “China” risk. This will benefit other Asian economies.

The only bright side of this very dark picture is that it seems to have already been priced into share prices, and valuations on the whole are now quite reasonable, whereas corporate earnings, after all, are expected to improve.

Moreover, international investors seem to have thrown in the towel, judging from the latest outflows of US and European investor funds. The market would therefore be sensitive to the slightest bit of good news. Meanwhile, some sectors continued to grow strongly, such as the green economy, for example (see chart below).

In contrast, emerging bonds performed well, as expected, with a gain of almost 6.5% this year. Both of the identified potential drivers of performance worked:

• Bond yields have fallen on the whole and particularly in Latin America to, respectively 185 and 240 bps on 10-year Brazilian and Colombian paper, but also by almost 200 bps in Hungary.
• Currencies, which are undervalued on the whole, have begun to make up some ground.

In short, yields in the asset class are still at a rather attractive level of almost 6.5% (vs. more than 7.5% at the start of the year). There is still some upside room in currencies. Note also that phases of stabilisation or weakening in the dollar and recoveries in commodity prices are rather good bellwethers for the relative performances of this asset class.

FIGURE OF THE MONTH

USD35bn

This is the surplus over the past 12 months of cars in China, vs. a deficit of USD 25bn three years ago!
This radical change is due to the spectacular development of electric vehicles in China.

TREND IN CHINESE CAR EXPORTS AND IMPORTS

(finished cars only)

Document completed on 06/07/2023